Morningstar Magazine - April/May 2018 - 23

Getting the Message
on Fees
AMERICAS

United States
Fund companies finally seem to be getting
more proactive about cutting fees. In response
to investors moving money to index funds and
low-cost actively managed funds, more U.S.
equity funds cut their expense ratios in 2017 than
in 2016. We looked at the expense ratios for
the nearly 1,750 actively managed funds that invest
predominantly in domestic stocks. We sampled
the expense ratio from each fund's oldest
share class and eliminated any funds that did not
have expense-ratio data in 2015, 2016, and 2017.
The difference from 2016 to 2017 was dramatic.
In 2016, only 469 funds, or 26.8% of the total, cut
their expense ratios. In fact, far more funds
(596 or 34.1%) increased their expense ratios in
2016, with the remainder remaining unchanged.
(To be fair, some of those increases likely
owed to performance-fee adjustments. See the
discussion below.)
The tide turned in a big way in 2017. Even though
more than 300 funds haven't yet reported their
2017 expense ratios, 655-nearly half the total of
reporting funds-cut their expense ratios in
2017. Meanwhile, only 258 funds reported expense
ratio increases, a 57% drop in funds that raised
their fees year over year.
Yet, while this change in direction is encouraging,
the degree of change was underwhelming.
The average cut in 2017 was just 6 basis points,
and the median was only a 3-basis-point reduction.
It's worth remembering the point we often
make: While the average fee that investors are
paying for active equity funds is falling, it owes
more to investors targeting low-cost funds
rather than to funds cutting their expense ratios.
Indeed, some funds continued to raise their
expense ratios even as money walked out the door
and assets fell. In most cases, these funds are
simply keeping their costs constant as assets fall,

which leads to a rising expense ratio, all else equal.
Our guess is that executives at these funds
don't think of this as raising prices, but the effect
is the same.
So, why were the price cuts in 2017 so modest?
Well, despite all the talk about clients coming
first, asset management isn't that different
from any other profit-maximizing industry. Most
management teams charge what they think
fundholders will bear. More specifically, most look
at what their peers charge and try to at least
stay in the ballpark.

in Fidelity's case, which cuts the fees on many
of its actively managed funds when their
rolling three-year returns lag their benchmarks.
That was the case with Fidelity Low-Priced Stock
FLPSX in 2017, which saw its expense ratio fall
21 basis points to 0.68%.
While adjusting fees based on performance is
laudable, investors should keep in mind that such
adjustments will reverse if relative returns improve.
Indeed, Fidelity Growth Company's FDGRX
expense ratio rose by 8 basis points because of
its strong recent results.

This is the function of annual 15(c) reports, which
show fund boards how much a given fund charges
relative to its peers. So, rather than setting fees
based on an absolute standard such as economies
of scale or a desire to maximize returns, fees tend
to be based on what other funds charge. This
means that fees can fall collectively, but cuts tend
to be modest and incremental.

It will be interesting-but not pleasant-to see
what happens to fees during the next bear
market as overall assets drop. For now, it's mildly
encouraging to see active U.S. equity funds
becoming more proactive in cutting their expense
ratios. Nevertheless, unless competitive
or market pressure increases, cuts are likely
to remain modest and incremental.

Still, it's notable that many funds reduced
their fees last year despite net outflows. (The
Department of Labor's fiduciary rule possibly
forced some fund executives' hands as well.)
Actively managed U.S. equity funds saw outflows
of nearly $200 billion in 2017. (For the three years
through January, the figure is about $570 billion.)

Kevin McDevitt, CFA, is a senior analyst with Morningstar

Nevertheless, as many have noted, a strong bull
market has bailed out active U.S. equity funds.
Despite all the outflows, actively managed
U.S. equity assets hit a 10-year high of nearly $4.5
trillion in January. So, rising assets should
give fund companies more room to cut expense
ratios. But not all funds that cut their fees
saw increased assets. Embattled Fairholme FAIRX
chopped its management fee by a substantial
20 basis points to 0.83% as of Jan. 1, despite about
$800 million in outflows in 2017 and a drop in
assets of more than $1 billion to $1.9 billion.
Management said that the cut was to compensate
for the fact that a large percentage of assets are
currently in cash and fixed income, but it's
likely that the firm is also trying to slow outflows
by becoming more cost-competitive.
Some funds saw their fees fall because of
performance adjustments. That's especially true

Research Services.

Tax Reform Shakes Up
Muni Market
The sweeping tax overhaul that passed in
December provided a wild ride for municipal-bond
market participants, and the law's longer-term
impact is still up for debate. But as we've talked to
portfolio managers since then, it's become clear
that most aren't expecting disaster, although there
have been some big changes.
Early versions of the bill included the elimination
of the tax exemption for both private-activity
bonds, or PABs, and advance refunding
bonds, keeping both muni issuers and buyers on
edge. PABs provide vital project financing
for various types of facilities, including nonprofit
hospitals, utilities, and multifamily housing
units. As PABs account for an estimated 20% to
30% of the muni market, and advance refunding
bonds generally compose 10% to 25% of
annual muni bond issuance, disallowing either
financing tool was expected to have a big impact.

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Table of Contents for the Digital Edition of Morningstar Magazine - April/May 2018
